Tags: Merk | QE | currency | Bernanke

Bernanke Put: Beware of Easy Money

By Wednesday, 26 September 2012 11:25 AM Current | Bio | Archive

Central bankers around the world might be providing a backstop to the financial markets in much the same way former Federal Reserve Chairman Alan Greenspan did during the “Goldilocks” years, but when the short-term euphoria wears off, will the negative repercussions be even more severe? Ben Bernanke’s Fed appears to specifically target equity-market appreciation as part of its offensive in bringing down the unemployment rate. Expectations are high; every time the market sells off, the Fed might simply print more money. We fear central bankers have overstepped their reach, and the implications of their actions might be much worse than the anticipated benefits.

To an extent, the effects of today’s monetary policies resemble the “Greenspan Put” in the years leading up to the crisis. Today’s central bankers have been quite straight forward in communicating their stance: they appear willing to step in with evermore liquidity should the global economy show any signs of further weakness. Bernanke has gone even further: the Fed has stated it’s accommodative policies will “remain appropriate for a considerable time after the economic recovery strengthens.” In other words, financial markets will be awash with liquidity for an extended period, even if we see signs of a sustainable economic recovery.

At first glance, this might appear as a positive development for investors holding stocks and other risky assets. After all, Bernanke appears willing to underwrite your investments for the foreseeable future. Indeed, Bernanke appears to specifically target equity-market appreciation, on many occasions noting one of the key benefits of quantitative easing (QE) has been to increase stock prices. Notably, while he believes the Fed’s QE policies have had a positive impact on stock prices, he considers it has not caused increases to inflation expectations or commodity prices. We disagree, which we elaborate below. Ultimately, the Fed might have reached too far, bringing risks to economic stability and elevated levels of volatility. The full implications of its actions might be somewhat dire down the road.

From the Bank of Japan and the People’s Bank of China to the European Central Bank, the Bank of England and the Fed, central bankers are either putting their money where their mouth is (quite literally) or strongly insinuating that continued, ongoing easing policies are needed to prevent another significant downturn in global economic activity. While all the excess printed money might or might not have the desired effect of stimulating the global economy, the money does find its way somewhere. Unfortunately, most central bankers appear to fail to realize that they simply cannot control where that money ends up.

Bernanke’s Achilles’ heel since the onset of the financial crisis has been the housing sector. It’s no surprise why the Fed has bought over a trillion dollars worth of mortgage-backed securities (MBS) since 2009: to re-inflate home prices and in so doing, bail out all those underwater in their mortgages. The problem was, it didn’t work. House prices continued to weaken across the nation and have stagnated to this day. Now, the Fed has announced another MBS purchase program, this time open-ended, under the auspices of QE3. Does the Fed believe the time is now ripe for MBS purchases to positively impact the housing market and thus the economy? Unfortunately, the first MBS purchase program failed to have its desired effect, and we do not foresee how QE3 will be any better at stimulating house-price appreciation.

One of the things we believe such actions do stimulate is inflation expectations. Indeed, the jump in market-implied future inflationary expectations in reaction to the Fed’s QE3 decision was quite remarkable.


In contrast to Bernanke’s views that QE does not cause commodity-price appreciation, in our assessment, much of the freshly printed money only serves to inflate the value of assets that exhibit the greatest level of monetary sensitivity: commodities and natural resources. These are essential in the manufacture and production of goods and services purchased by U.S. consumers on a daily basis. As such, inflated commodity and resources prices ultimately pressure consumer price inflation, as the consumer’s “everyday basket of goods” becomes evermore expensive. The ongoing weakness in the U.S. dollar only serves to compound these inflationary pressures. A weak dollar, we believe, is part of Bernanke’s strategy to stimulate the U.S. economy through stimulating exports. While we fundamentally disagree that this is sound monetary policy for the United States to pursue, the inflationary ramifications are clear. The United States imports a great deal from abroad; every time the dollar depreciates against a currency of a country from which the country imports, the price of those imports rises.

Not only have the Fed’s actions heightened inflationary risks, but we also believe it implicitly heightens the risk that the Fed gets monetary policy wrong. For instance, Bernanke believes that the Fed’s nonstandard policies since 2008 might have helped lower 10-year Treasury yields by over 1.5 percent. In so doing, the Fed has taken away a key metric used to gauge the economy and thus set appropriate monetary policy: free-market interest rates. The Fed has historically relied on long-term yields, such as the 10-year and 30-year Treasury yield, as part of its assessment of the overall health of the economy. In manipulating those same yields, the Fed can no longer rely upon them to provide valuable information on the health and trajectory of the economy. In other words, the more the Fed meddles in the market through nonstandard measures, the more the Fed is in the dark regarding the appropriateness of monetary policy. Such a situation inherently creates an additional level of uncertainty over the U.S. economy and U.S. monetary policy and might continue to underpin weakness in the U.S. dollar.

The vast amounts of liquidity provided via the Fed’s QE programs will, at some point, have to be reined in. Whether due to inflationary pressures or a sustainable recovery, only time will tell, but the need to rein in liquidity could create massive headaches down the road. Given the ongoing high level of leverage employed in the economy, such monetary tightening runs the risk of undermining any economic recovery and potentially causing it to crash back down, as the likelihood of it negatively affecting consumer spending is high. With a still-leveraged consumer, rising rates might be overly painful, dramatically slowing consumer spending and, in turn, the economy. Such dynamics might have an outsized impact on the U.S. economy, given consumer spending makes up approximately 70 percent of U.S. gross domestic product.

All of which underpins our view that there is a significant risk the Fed has gotten monetary policy wrong. We consider the Fed’s actions have not only heightened inflationary risks, but have also inherently created risks to appropriate monetary policy going forward. Both of which will likely contribute to ongoing high levels of market volatility over the foreseeable future.

With so many dynamics yet to be played out globally, and with central bankers becoming evermore active in meddling with economic dynamics around the world, investors might want to consider preparing for the potential ramifications of such policies. While we might disagree with the policies being pursued, central bankers appear to be at least predictable in their decisions. We believe the currency market provides the most effective way to position oneself to protect and profit from the implications of such monetary policies.

In the current environment, the general equity market seems to be moving on the back of the next anticipated move of policymakers and less so on fundamentals, but company-specific risks remain. With the outlook for the economy still on tenterhooks, many companies have been missing earnings forecasts. Currencies don’t have this additional layer of risk. As a result, currencies might be the “cleanest” way of positioning oneself for the next policy move. Historically, currencies have also exhibited much lower levels of volatility relative to equities, when no leverage is employed. As such, investors might want to consider adding a professionally managed basket of currencies to their existing portfolios.

We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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In the current environment, the general equity market seems to be moving on the back of the next anticipated move of policymakers and less so on fundamentals. Currencies might be the “cleanest” way of positioning oneself for the next policy move.
Wednesday, 26 September 2012 11:25 AM
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